A broad spectrum of investment vehicles exists today allowing investors to take positions having a corresponding broad potential return and exposure to loss. For many years, professional investors have enjoyed the use of derivative investment vehicles to hedge or off-set positions and control risk. Risk management is a key desire among investors, and a corresponding growth in the use of futures contracts is reflective of their increasing role as risk management tools.
Futures contracts have a long history as risk management vehicles. Initially used in the agricultural field, farmers would employ futures contracts on their products to lock in a profitable price for their products. This was in effect a “hedge” against the risk of crop price drop and a loss suffered by the farmer due to the lower price commanded by the crops in the marketplace. The futures contract was an agreement by the farmer to deliver the crop at some future date, at a select (profit bearing) price. This contract was entered with a market speculator, gambling that the crop price would rise above the contract price on the delivery date. In the agricultural setting, speculators would often be joined by grain processors (e.g., cereal manufacturers) on the buy side of the contract, to lock in the price of a raw material (grain) for their products—again for risk management, but on the cost side.
As these contracts grew in popularity, markets quickly appeared and became proficient in trading the actual contracts as a separate asset class. These futures markets became highly liquid, offering investors quick access to risk management tools in a number of raw materials and commodities, including sugar, precious metals, soybeans, oil, and the like. As the traders gained experience with these tangible asset classes, the markets expanded into financial assets, such as government bonds, currencies, stocks and of particular concern here, stock indexes, such as the S&P 500.
Stocks and in particular stock indexes added a new complexity to the futures contract. As seen above, the futures contract was principally concerned with gaining access to a specified material at a pre-determined price. Accordingly, these early contracts, when due, resulted in the delivery of the underlying commodity—such as wheat—at the contract price. For a contract on an index, to deliver the underlying shares in the index would be unnecessary in view of the ready supply of the corresponding shares on other markets. The seller would instead, per the contract terms, deliver the difference between the contract price and market price for index stocks at the contract date, known as a cash settlement. In this way, the index futures contract becomes completely decoupled from the transaction costs associated with the underlying assets (here stocks).
An index futures contract is therefore a transaction that exchanges cash for the future value of the corresponding index. Much like other futures contracts, a highly liquid market has developed for trading the futures contracts on indexes. A particularly useful example of this involves the S&P 500 Index as originated and published by Standard and Poor's, Inc. It is an index of the 500 largest companies based on market capitalization and is a well respected barometer of the general United States equity markets. In this market, S&P 500 futures contracts are offered with corresponding bid-ask price spreads, and traders buy and sell these contracts, going long or short in the general equity market.
Futures contracts are traded on regulated exchanges, such as the Chicago Mercantile Exchange (“CME”). The purchase and/or sale of futures contracts are made with licensed and trained brokers facilitated through the use of clearing agents. Typically, futures contracts are bought on margin, of approximately 5-10% of the index contract price. Because settlement involves the (phantom) delivery of the underlying shares at some future date, the contract price is greater than the index. This reflects the difference between the cost of holding the underlying stock (cost of finds, but return of dividends) and the contract (no funds, but no dividends). As the settlement date approaches, this differential narrows, and disappears on the settlement date.
As time progresses towards the settlement date, the stock prices go up and/or down and the index fluctuates in concert with corresponding impact on the contract holders. If, for example, the index drops, the long position may be required to provide more cash so as to maintain the margin for the account (known as “maintenance margin”). Also, this “marked to market” pricing has tax implications and is considered a taxable event at year end.
Index futures contracts have become very popular with large institutional investors, such as pension funds, insurance companies, banks, and the like. Index futures contracts are particularly valuable for hedging against, or speculating on, large general price movements in the equity market. Because simple diversification does not protect a portfolio from an across the board drop in equity prices, these institutional investors look to the index futures markets for help. Portfolio managers hedge against a drop by selling index futures contracts for the period in concern. If the market drops, the value of the index futures contracts—depending on the amount sold—will buffer the impact on the portfolio, protecting its value from the downside market swing. As most fund managers are long term holders of equity, the index futures contracts become an incredibly efficient hedge against a loss in “inventory” value.
While perhaps the most efficient and versatile investment available, the use of futures contracts is primarily limited to institutional investors for a number of reasons. For example, the market has developed into a field particularly structured for large institutions as the contract sizes are relatively large (e.g., the minimum contract size of an S&P 500 futures relates to approximately $350,000.00), purchases are highly regulated with margin limits and the pricing of these instruments, involving the corresponding assessment of interest rates and dividend yields, is complex. Indeed, even the tax consequences are designed with the institutional investor in mind. These factors have prevented small investors from any meaningful participation in the index futures markets and has thus deprived this growing investor class from the efficiencies and risk management benefits attendant with index futures contracts. It was with this understanding of the current market conditions that led to the present invention.